DEALMAKER GUEST BLOG -- TONY KUHEL

With earn-outs still prevalent, dealmakers should know how to structure them

Blog Entry: December 04, 2013 9:24 AM | Author: TONY KUHEL

Tony Kuhel is a partner in Thompson Hine's Corporate Transactions & Securities practice group and is vice chair of the practice in Cleveland. He focuses his practice on mergers and acquisitions, private equity and venture capital transactions.

When there is difficulty in valuing a business, either because of market uncertainty, limited operating history of the target or a recent decline in the target's earnings, a buyer and seller may look to bridge the gap in valuation that exists between them. An earn-out is a tool designed to do just that.

An earn-out is a form of contingent consideration payable to the seller based on the achievement of performance targets after the closing of a deal. Given the uncertainty in the market since late 2008, earn-outs continue to be prevalent in private mergers and acquisitions.

Here are a few key considerations in structuring earn-outs:

Earn-out targets. The targets used to determine whether an earn-out is paid may be financial or operational (or both). For example, typical financial targets include specified thresholds based on revenues, net income or EBITDA (earnings before interest, taxes, depreciation and amortization). Operational targets may include the launch of a particular product or an increase in customers. In either case, the parties must define clearly the performance target and how performance will be measured post-closing.

Earn-out period. Careful consideration should be given to the length of the earn-out period. Obviously, the seller prefers a short period and the buyer generally prefers longer earn-out periods. However, if there are post-closing covenants that impact the buyer's operation of the business during the earn-out period, the buyer may prefer a shorter earn-out period. Earn-out periods typically range from 12 to 36 months, with one payment made at the end for earn-outs of shorter duration and multiple payments made at the end of each year for multi-year earn-outs.

Payment terms. The payment upon achievement of the earn-out is generally structured as a flat fee, a multiple of the amount by which the business exceeds the earn-out target or a percentage of the earn-out target. For example, if the overall purchase price was determined based on a specific multiple of the business's EBITDA, then it may be appropriate to tie the earn-out to EBITDA and the payment to be a multiple of the overall amount by which the business exceeded the specified target. Parties often specify a maximum amount payable, or a cap, in the event that the business far exceeds the earn-out target.

Covenants. The sellers often will seek to require the buyer to operate the target business in accordance with certain post-closing covenants in order to help ensure that the business is positioned to achieve the earn-out. Post-closing covenants vary from the benign (like a requirement that the buyer maintain separate books and records for the business) to the intrusive (like the use of best efforts to achieve the earn-out). Given the restrictions that post-closing covenants may impose on the buyer's ability to operate the business, the buyer may seek to negotiate for no post-closing covenants. Operational covenants and covenants that may be viewed as a guaranty are typically problematic for the buyer.

Dispute resolution. The parties should determine who will prepare the initial financial statements and the calculations relating to the earn-out. The parties also should be as specific as possible in describing the accounting principles to be used for the earn-out calculations, including the treatment of post-closing acquisitions, shared costs and expenses and any extraordinary or non-recurring items. The earn-out should establish the time periods for review of the calculations and how disputes will be resolved (for example, which independent accounting firm will be engaged and the time period and procedures for the accounting firm to deliver its calculations).

Acceleration; buy-out option. In structuring an earn-out, the seller and buyer need to agree on whether any actions will result in the acceleration of all or any portion of the earn-out. For example, the sale of the target business during the earn-out period or the termination of key executive officers could result in all or some portion of the remaining earn-out payments becoming immediately due and payable. Acceleration gives the seller some assurance that the buyer may not take certain specified actions that could impact adversely the performance of the business or the ability to make the earn-out payments when they are due. Alternatively, the buyer may request a buy-out option allowing the payment of a specified amount to satisfy any remaining requirements under the earn-out and releasing the buyer from its ongoing obligations related to the earn-out.

Other considerations. The parties should ensure that payment of the earn-out is permitted by the financing documents of the target business. In addition, parties considering use of an earn-out should consult their financial advisers to discuss the implications of the accounting treatment of the earn-out. It may be appropriate in certain transactions to seek a guarantee or other form of security for the buyer's payment obligations under the earn-out.

An earn-out can be an effective tool to address differences in opinion regarding the value of the target business in a private merger or acquisition — when properly negotiated and drafted.

Reader Comments

Readers are solely responsible for the content of the comments they post here. Comments are subject to the site's terms and conditions of use and do not necessarily reflect the opinion or approval of Crain's Cleveland Business. Readers whose comments violate the terms of use may have their comments removed or all of their content blocked from viewing by other users without notification. Comments may be used in the print edition at editorial discretion.